Bears rule

With the crisis in global markets far from over, the current bear phase in our markets is likely to extend into the second half of 2009.

The markets are in a firm bear hug. The Sensex has lost 15 per cent last week with a large chunk of those losses coming on Friday when the benchmark index sank 10.96 per cent to 8,701 points. Friday’s fall takes the total year-to-date decline to 57.1 per cent, a level where gains made in the last three years stand wiped out. Faced with redemption pressures and the need to shore up their own capital, FIIs and hedge funds have offloaded shares in the Indian market.

Fear and its close cousin, risk aversion, have ensured that investors are opting for cash, government paper and fixed deposits rather than equities or corporate debt. To make sense of the current bear market and those in the past, The Smart Investor analysed past data to understand bear cycles, their duration and the time it takes to come out of it.

Understanding the bear

While there is no standard definition of a bear cycle, it is largely defined as a price erosion of 20 per cent or more and time duration of three months, in the case of developed markets. For emerging markets like India, a bear cycle is typically defined as a price erosion of over 33 per cent and a minimum period of six months. There are five bear cycles that fit these criteria with the longest coming in 1994 and the shortest in 1996.

Despite different time periods and divergent macroeconomic trends, the bear cycles follow a similar pattern. There is a sharp price correction when the markets bottom out with losses ranging from 35-60 per cent. This is followed by time correction, which is long and painful wherein markets move sideways accompanied by sluggish volumes, and are in a consolidation mode.

The bear cycle that followed the bursting of the dotcom bubble saw the market drift listlessly for two years between September 2001 and August 2003. Deepak Jasani, head of retail research, HDFC Securities summarises the bear cycle. “The markets top out (January 2008) as investors move from euphoria to anxiety and denial mode. In the beginning, there is hope that things will turn out for the better. But, hope vanishes and is replaced by fear, desperation, panic and finally capitulation (the current phase). What we could be headed for is the despondency and depression phase, which culminates in an upturn when people start to believe that the worst is over.”

What makes this cycle different?

While there have been occasions in the past when markets have been at the receiving end of a regional crisis, never have so many countries been engulfed in a credit crunch of this magnitude. Says Vinod Nair, deputy head, research, Religare Hichens Harrison, “While many countries have bailed out their banks and financial institutions, some like Pakistan, Argentina, Ukraine and Iceland have gone bankrupt with no money to pay for their bills.”

While the current bear market is much bigger than a cyclical bear market, it may not be as severe as the ‘1929 Depression’. “The current phase looks severe as business and consumer confidence is shaken and it might take a long time to restore it,” says Nair. This results in a cycle where consumers and businesses don’t trust each other and cash is king. Says Deven Choksey, managing director, K R Choksey, “The fall in the value of collateral and a credit squeeze has meant that banks and NBFCs offload shares to recover their dues triggering a fall in a weak market.”

One of the key differences in the current bear phase is the extent of overseas investment. Says Jasani, “In bull markets of 1992 and 2000, local money was supplemented by FII investment.” In the current cycle, FIIs have been the key reason for the bull march and have also as a consequence been the number one reason for the drop. There are differences on the valuations front as well.

Unlike in the past, P/E levels are reasonable and backed by sustained and robust corporate earnings. The current bear cycle has also buried the decoupling theory for good. Says Madan Sabnavis, chief economist, NCDEX, “The stock markets are driven by funds, which have diversified portfolios. A loss in one segment forces them to make good the loss by selling in other segments and countries, which in turn causes the contagion.” While there have been differences on many fronts, what have been the characteristics of the previous bear phases? Read on.

April 1992 – April 1993

The first bear phase saw the markets drop by 53 per cent. This was a period which immediately followed the opening up of the Indian economy in 1991 and was the starting point for corporate investment. It came after a period of negative industrial growth, double digit inflation and a dismal 1.3 per cent GDP growth in FY92. While high interest rates of 17 per cent prolonged the slump, the trigger for the crash was the securities scam.

A bubble created by the money borrowed from banks and invested in select group of stocks by Harshad Mehta and the subsequent liquidation of positions created in various stocks sunk the markets. Unsustainable valuations (Sensex was trading at 37 times earnings) were a result of theories such as replacement value, which gave obscene valuations to mature companies. ACC, a favoured stock of the Big Bull, saw its price move up over 200 per cent to Rs 10,500. A one year fall was followed by a short consolidation phase (associated with sideways movement) of three months.

September 1994 – December 1996

India Inc never had it so good with the benefits of liberalisation reflecting in industrial growth touching a high of 13 per cent in FY96 and three consecutive years of 7 per cent plus GDP growth (FY95-FY97). Lower interest rates and a flexible exchange rate meant easy access to finance with corporates raising about $7 billion in the overseas markets between 1994-96.

Says Manish Sonthalia, senior VP research & strategy, Motilal Oswal Securities, “There was huge capacity build-up (led by steel and textiles) and GDRs were in vogue. An economic downturn caught them off-guard.” Excessive valuations (Sensex PE at 44 times in 1994) and tightening monetary stance in 1996 to cut inflation ahead of elections saw the stock market tank about 40 per cent. This phase was also marked by overpriced IPOs. The bearish period lasted for 17 months bottoming out in January 1996. It was followed by a consolidation phase, which included a bear market rally and a sharp correction over the next 10 months; excluding this, the phase lasted for over two years.

August 1997 -- December 1998

This bear phase was one wherein markets fell the least as compared to other phases. While some experts suggest that it is part of the bear phase that started in September 1994, others have taken it as a separate case. This was the phase of industrial recession when growth came down to 6.7 per cent in FY98 and 4.1 per cent in FY99. The impact of the Asian crisis was also felt here in terms of the rupee falling sharply by around 15 per cent. The monetary tightening in FY96 when the CRR was raised by around 150 basis points also constrained industrial growth. Factors such as excess capacity also contributed to this decline in investment and industrial growth.

February 2000 -- September 2001

Despite interest rates coming down, this period witnessed a dip in industrial growth for FY01 and FY02. The phase saw large bankruptcies of Enron, WorldCom and the closure of Arthur Andersen. However, it will be best remembered for the dotcom bubble with prices and valuations of information technology, communications and media companies going through the roof globally. When sanity returned, the markets lost more than half of its value in most of the new economy companies.

Among the prominent names, Wipro fell the most shedding nearly 84 per cent. The crash brought to the fore funding arrangements of Ketan Parekh and propping of K10 stocks such as DSQ Software, Pentamedia and HFCL. The Sensex and the Nifty were down by about 51 per cent in a period of 19 months bottoming out in September 2001. What was even more painful was the sideways movement after this that lasted nearly two years till August 2003 stretching the bear grip to well over three-and-a-half years.
 

THE CURRENT SITUATION

* The Sensex has fallen by 59 per cent since its peak in January 2008

* From Rs 1,100 levels, Sensex earnings have been cut to Rs 940 for FY09 

* GDP growth forecast lowered to 6.9 per cent for 2009 by IMF

* Companies postpone new projects, go slow on current ones

* High interest rates- PLR at 13.75 per cent, are hurting earnings

* While call money rates are now down, availability of credit is a big issue

* Tight domestic credit conditions, access to foreign markets for funds virtually non-existent, IPO market listless

* Huge redemption pressure across markets; EMs worst hit

* FIIs have pulled out $12 billion from the Indian markets YTD 

* MSCI Emerging Market Index is down 57 per cent YTD

* Some countries may default; US, UK and Singapore seen in recession

January 2008 -- ?

Global factors have played a key role in the current slump. The credit crisis, which came to light in August 2007 coupled with high inflation, interest rates and rising crude prices, has led to the start of what looks like a global equities meltdown and Indian markets have moved lock-in-step with events unfolding outside the country. Among the sectors which gained the most at the start of the bull-run were infrastructure, banking and realty.

The housing sector, not surprisingly is bearing the brunt of the bears. BSE Realty index down by 56 per cent over the last one month and over 82 per cent in the last one year. That apart, there are many stocks that have lost between 60-80 per cent of their values from the peak. While this suggests that the froth (steep valuations) which had formed is now vanishing, the problems are far from over (see: The current situation).

Unlike the past bear phases, the valuations of companies from the ‘real economy’ at the peak in January were not as high as those witnessed in the 2000 dotcom period nor has there been any report so far of any scams or manipulation, which has been an integral part of some of the earlier crashes. Like the bear phase in 2004-2006, pharmaceuticals and FMCG companies have outperformed falling by only 26 per cent and 15 per cent, respectively.

Conclusion

We are ten months into the bear market and there is no bottom in sight for the Sensex and other world indices, despite the massive, coordinated $3 trillion global liquidity injection by central banks around the world. So, how long will the pain last? Experts are divided on it. Nair opines that the market will bottom out between 8,500 and 9,500 with the consolidation phase lasting anywhere between 12-18 months. Jasani believes that bear markets last between 13-21 months. “When the viewership of business channels touches all-time lows, it could reflect that people have given up all hopes and the worst is over,” he adds.

The current problems for companies is not about their long-term prospects or the robustness of their business models, but of their ability to weather out a tough period where credit is hard to come by to fund operations and expansions and consumers cut down on spending and investments in various asset classes and put their faith in cash. Companies such as Hindalco, Tata Steel and Tata Motors are not only reeling under the prospects of a tough business outlook, and are also saddled with debt obligations on account of large acquisitions. Similarly, Indian companies, which have together raised $31 billion in overseas debt (including convertible bonds) over the last four years ($16 billion in 2007), are likely to find it tough to meet their obligations as they come up for payment over the next three years.

While the current macroeconomic situation suggests deteriorating fundamentals, the government and RBI seem to acknowledge the credit problem by taking a number of measures (cut in CRR and repo rate, relaxation of ECB norms, help to airline companies by extending their fuel credit and putting money into public sector banks to enhance capital adequacy ratios), which should help the economy and corporates tide over a difficult situation.

The declining commodity prices and interest rates are also positive. While these events and measures provide some cushion, the global crisis is not yet over. Besides, the market is yet to signal a bottom, and a few people are still in hope (denying a bear market). If history is of any evidence, the phases of despondency and depression will also be seen, before things turn for the better.

The impending elections (May 2009) will only add to the volatility, as the day approaches. The best option for investors in a tough environment like this is to stick to companies that are not excessively leveraged, are not in a middle of expansion, have strong entry barriers, possess high levels of cash and can withstand the strain on credit, which is going to get worse over the next six months.